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By Morningstar.com | 03-11-2017 02:00 PM

Top Investment Ideas for Retirement

Retirement Readiness Bootcamp Part 5: Morningstar strategists share their top fund, ETF, and dividend stock picks to fill your retirement portfolio.

Karen Wallace: For Morningstar, I'm Karen Wallace, and welcome to back to the Retirement Readiness Bootcamp. In this session, we're going to talk to four Morningstar specialists and get their best investment ideas today. If you have questions for our panelists, please feel free to submit them through your player. Joining me now is Russ Kinnel. He's director of manager research for Morningstar and editor of our Morningstar FundInvestor newsletter. And Ben Johnson, he's director of global ETF research and editor of our ETF Investor newsletter.

Russ, Ben. Thanks so much for being here.

Russ Kinnel: Good to be here.

Ben Johnson: Thanks for having us.

Wallace: Thank you both for being here today. Christine has just talked about her bucket portfolios and some approaches to asset allocation. Let's talk now about how to find some good investments to fill up those buckets. Maybe we could start with some of our best ideas for core headings. Perhaps, maybe we'll start with conservatively minded investors. What do you think are some funds that are easy to own?

Kinnel: On the open-end side, I like FPA Crescent as kind of a conservative version of an equity fund. Steve Romick's just a really creative investor. Not just longs, he has some interesting private investment ideas sometimes. Even some shorts. Holds a lot of cash so on the whole, the fund tends to be pretty conservative. Pretty good at protecting on the downside. But he's also just got a great record, so that's one of my favorites, a really unusual fund. That's FPACX by the way.

Wallace: OK. And Ben, anything for sort of a core holding, something that will let you sleep at night, kind of thing?

Johnson: I think it's easy to sleep holding a very broadly diversified representation of the U.S. stock markets. For this particular bucket, I would take a look at the Vanguard Total Stock Market Index Fund. There's an ETF share class. There's an admiral share class. Vanguard has a unique structure whereby its ETFs are simply just a separate share class of their mutual funds.

Wallace: This one's ticker VTI.

Johnson: VTI is the ticker for the ETF. That's correct. So if you want broadly diversified exposure to the U.S. stock market, market capitalization weighted, all at a very, very low fee, Vanguard Total Stock Market Index Fund is a fantastic choice. Will help you sleep well tonight, tomorrow night, and for many nights to come.

Wallace: Well, that sounds great. Maybe there's something we can talk about, maybe some ideas for investors with a little bit more moderate risk tolerance. How about with an open-end fund?

Kinnel: Well, sure. One of the ones I like is T. Rowe Price Dividend Growth, ticker PRDGX. That's a Silver-rated fund. Tom Huber has quietly done a really good job at that fund. And what I like is the dividend growth strategy because it'll look for companies that have the potential to keep growing their dividends. That means they have to have good balance sheets, pretty sound businesses, so it's got some kind of nice defensive characteristics built in. In the '08, '09 bear market, we saw those strategies lose less. They still lost money, but they lost less than most other strategies, so I think that's another good core holding.

Johnson: I would take a look at the Vanguard High Dividend Yield ETF. The ticker for that is VYM. This is another fairly straightforward portfolio, so what the underlying index does is it looks at the U.S. stock market. It takes the highest yielding half of the U.S. stock market, weights those stocks by those market capitalization and charges a really low fee for doing so. So when you look at the different dividend strategies that are out there, I would cleave them roughly in half into dividend-growers--so higher quality firms that are very cash generative, have sound balance sheets that can grow their dividend payments with time; those are high quality companies, companies with wide economic moats. In the other bucket, you have dividend-yielders. Funds, indexes or actively managed funds that just look for stocks with higher than average dividend yields. This particular fund is interesting in that it shares characteristics of both buckets. You get a bit of a higher yield, but relative to other yield-oriented strategies, it's also got one of the greatest loadings on sort of quality, one of the greatest representations of firms with wide or narrow economic moats in the portfolio. I think if you're looking for equity income in particular, something that might be a little bit more risky, this is something I would absolutely take a look at.

Wallace: OK. So those higher yields don't necessarily go hand in hand with the highest quality companies.

Johnson: No. So high yields, to be clear, can come about for any number of different reasons. A firm could simply be down on its luck for a short stretch of time, or you could be entering the business of catching falling knives. The thought here is that if you own enough of these, the falling knives don't harm you nearly as much as the firms that are simply out of favor that are actually probably good values for one reason or another are going to wash out and getting the negative effects, again, of getting a knife or two lodged in your knee.

Wallace: Got it.

Kinnel: Sounds unpleasant, Ben.

Wallace: It does. And finally, let's talk about some funds that might appeal to investors with maybe a very long time horizon, a higher risk tolerance than others.

Kinnel: One of my favorites, Primecap Odyssey Growth. I'm a big fan of Primecap. Maybe the best growth investors out there. They're based in Pasadena. They've won our manager of the year award. They're better fundamental investors than mostly growth investors out there. They just know their companies better. They've got a very experienced, skilled analyst staff. Ticker POGRX. We rate it Gold. It only charges 65 basis points. We look some of the index funds Ben's recommending might charge 10. You're only paying 55 basis points more for some amazingly good managers.

Wallace: Some of the Primecap funds are closed but this one is not. Is that correct?

Kinnel: Right. Primecap Odyssey Growth is still open.

Wallace: Ben, what can you recommend in the ETF space?

Johnson: Here, I'd take a look at the iShares Edge MSCI Multi Factor USA ETF. That's a mouthful. The ticker for that is LRGF, which is less of a mouthful. This particular fund tracks an index that looks at the universe of U.S. stocks, and it tries to select from that universe of U.S. stocks those that are showing the strongest characteristics of different factors. Things like value, cheap companies. Things like momentum, companies whose share prices are appreciating and are likely to continue to appreciate. It combines these different factors, all under one roof, make some pretty sizable factor bets in terms of order of magnitude. To stress here too all of these factors it should be understood have been associated with market-beating performance over long periods of time, so if you put them all under one roof, you diversify your factor bets. In this context you do it in a very diversified, very low coast manner, package it into a tax-efficient ETF. I think this is a compelling option for people who are interested in factors more generally and multifactor funds in particular.

Wallace: You mentioned factors. There's been sort of a wave of, I guess, alternatively weighted index, so called smart beta, or we call it strategic beta here at Morningstar. What are they and how should investors think about using these in a portfolio?

Johnson: Great question. The strategic in strategic beta alludes to the fact that there's a strategy here. There's a strategy that is probably very similar to a strategy that's employed or has been employed by an active manager for a long stretch of time. Again, value being a factor, let's look for cheap stocks. Active managers have one way of doing that. Active strategies that are codified in an index format have another way of doing that, so let's just look for stocks with low price to book ratios, low price to earnings ratios and put them all into an index, rebalance, set it, and forget it. So, strategic beta takes an active strategy and tries to marry it with all of the best attributes commonly associated with passive funds or index funds, which are low cost, relatively lower turnover, and importantly, taking away certain kind of idiosyncratic risks, certain surprises. So my fund manager decides that they're going to pick up their marbles and go play marbles down the street. What do I do now? My fund manager potentially loses their marbles. What do I do now? So that idiosyncratic risk, taking the human element out of there ensures that that strategy is implemented with discipline. It's delivered at a low cost. Again, trying to marry the best of both worlds, from active and passive.

Wallace: OK. Let's turn the discussion to domestic versus foreign equity. We actually have a reader question about how investors should think about currency risk in their portfolios. Do you think that most investors would benefit from having exposure to international equity?

Kinnel: I certainly do. I think right now the U.S. has had a tremendous run up, so most U.S. equities are fairly high valued and valuations around the rest of the world are significantly lower. And therefore you have less price risk. I think, actually, foreign equities today are less risky. Most foreign equity funds are not hedged, so you are taking on some currency risk, but if you're a long-term investor, that really shouldn't matter too much. If you're sort of at the late end of retirement, then currency risk starts to matter. If might make more sense if you have foreign exposure to have that hedged, but for most long-term investors, I think it's fine.

Johnson: I would generally agree with Russ, though, that the case for investing in stocks outside the U.S. is a difficult one to make right now. I mean, you look back at the MSCI USA index, relative to the MSCI All Country World ex US Index, so everything that's not the U.S. You go back three, five, 10, 15, even 20 years and the U.S. stock market is just been performing spectacularly well, relative to the world at large, so it's a difficult case to make, the case for diversifying outside the U.S., but I think it absolutely has merit because there are inevitably going to be ups and downs. There are going to be regime changes. In all contexts and all settings as it pertains to portfolio construction, it makes sense to pair things that zig when others zag and those and zag when others zig. I think the same applies to investing in stocks outside the U.S. and adding them to a portfolio that might be predominantly made up of U.S. stocks.

Now as for the currency piece of it, I absolutely agree with Russ. Over a very long period of time, currencies are a zero sum game. There's not, like in equities, some sort of positive risk premium, some expected positive return there. The euro and the U.S. dollar are going to essentially seesaw relative to one another over short periods of time. Sometimes those changes can be pretty dramatic, like we've seen recently between the euro and the dollar, between the dollar and the yen, but over a long period to time, trying to time those changes is absolute folly. No one's ever done it well. I would guess that of the thousands of people who are tuned in today, they would be hard pressed to name someone who's made countless billions of dollars speculating on currency movements. I would advise to be cognizant of currencies and the risk associated with currency exposure, but don't think of it as prospective source of return. As a source of risk, potentially a source of incremental diversification.

Kinnel: I'd like to return to your earlier point, Ben, about the fact that the U.S. has outperformed most foreign measures over most the trailing periods. So as a contrarian, to me, that makes the case for foreign, that the last time we saw this was maybe 1999 when people were saying, foreign is for losers, you don't need it. U.S. does everything so well. And then the U.S. massively underperformed. Usually you have those value corrections, so to me this is a good time to move a little money from U.S. to foreign.

Johnson: Russ, you write a piece every year, Buy the Unloved, and I would agree, I don't think there's anything potentially more unloved right now than foreign equities.

Wallace: Let's talk about some picks in foreign equity. Maybe open-end funds?

Kinnel: Sure. So start off on the low-risk side, I like American Funds Capital Income Builder, ticker CAIBX. This is a fund that like the rest of American Funds recently became available in no transaction fee supermarkets like Schwab, Fidelity, etc. This is a fund that searches out higher yielding equities around the world. American has a great staff of analysts and managers so it's a nice steady fund, and it provides a nice yield as well.

Wallace: OK, and this is in the world allocation category?

Kinnel: This is in the world allocation, yes.

Wallace: And Ben, what is in the ETF universe that you like for foreign exposure?

Johnson: In the ETFs and index fund universe, I like the Vanguard FTSE All World Ex US ETF. The ticker for that is VEU. Again, as dull as watching paint dry and grass grow at the same time, and that is a good thing. Broadly diversified, market capitalization weighted, very low turnover, very low costs--a fantastic core portfolio holding for a huge number of investors who are looking to invest in stocks outside the U.S.

Wallace: So these would be good for investors that are a little more conservatively minded, would you say? What about an investor who is OK taking a little bit more risk in the foreign equity investing world. Russ, what do you think?

Kinnel: One I like is Harbor International, ticker HAINX. Northern Cross Portfolio Managers, really experienced, really good investors. Great track record. It's currently slumping, the last three or five years, not so great. But again, I'm a contrarian. I like that because it tells me maybe this sort of stocks they like have been out of favor and are due for a strong rebound. A nice, relatively focused portfolio, so I think a really good holding.

Johnson: I would have a look at the Schwab Fundamental International Large Company ETF. The ticker for that fund is FNDF. That ETF fits into that strategic beta bucket that we were talking about earlier, and tracks an index that has embedded in it intellectual property from Research Affiliates. So the Research Affiliates fundamental index methodology, which is effectively a value strategy. It is, I think, again, almost a mechanical way of being deeply, sometimes, deeply contrarian. What that does is it doesn't weight stocks by market capitalization. It weights them by some fundamental measure of their economics, their underlying economics, be it their earnings, their book value, what have you. As stocks get cheap relative to those measures, it doubles down on those stocks. So again, its a fundamentally contrarian strategy. It's one that has panned out in other markets over time. It's one that in this ETF is investable at a very low cost, and being packaged in an ETF wrapper is also relatively more tax efficient than some of the mutual funds out there that might have similar levels of turnover. So, FNDF is worth a look if you're looking for a more aggressive approach to investing in stocks outside the U.S.

Wallace: Got it. OK, and Russ, I think you had another pick for, another aggressive pick for foreign investors?

Kinnel: That's right. I like Matthews Asian Growth and Income, MACSX. It's a mix of emerging markets and developed in Asia, so that makes it a little riskier, but because it's got an income focus, they buy income producing stocks, they buy convertible bonds, other bonds, that actually dampens some of that risk. And Matthews is just a firm that really knows Asia well. That's their focus for all their funds, so I think they're a really good bet. I really like this fund as a long-term investment. You definitely don't want to make it a three-year holding. It's got to be a long-term investment, and I think it should pay off well.

Wallace: OK. I have one reader question that you sort of touched on, so I thought maybe it would make sense to throw it in here. A reader wanted to know what are the meaningful differences between mutual funds and ETFs in general, and specifically for retirement investors?

Johnson: I think the most meaningful difference is really just structural. So if you think at a very high level, an ETF and a mutual fund are just different ways of taking intellectual property strategies, be they active, be they passive, be they strategic beta, from an asset manager and delivering them to an end investor. One is listed on an exchange, the ETF. The ET in ETF stands for exchange traded. 

The other important structure different between ETFs and mutual funds is the way in which investors' money comes into and goes out of these funds. In the case of ETFs, ETFs are securities, securities out. When investors subscribe for new ETF shares, there's someone out there that takes all of those various stocks, gives them to the ETF company. The ETF company in turn gives them shares to go out and sell on the exchange. The same happens in reverse. When people want to take money out of the ETF, the authorized participant, I'll use some jargon here, takes all these ETF shares, gives them to the provider, they get stocks back. Because these are in-kind transactions, there's no taxable event that is unlocked.

Wallace: So they're not selling the securities and creating a capital gain?

Johnson: Exactly. Which is important, because you see certain ETFs, certainly strategic beta ETFs that might have 150%, 200% turnover in any given year that throughout their history have never distributed a taxable capital gain. Mutual funds, very different, in that it is a cash in, cash out proposition. So when investors take their cash out of funds--and we've seen a ton of this going on in actively managed U.S. equity funds in recent years--that's going to unlock embedded capital gains. Those capital gains distributions are going to be passed out to the end shareholder, which depending on whether you're holding them in a retirement account, or a taxable account, is going to present you with a real cost. Specifically to retirement investors, in the context of retirement accounts, you should probably be agnostic between these different structures. But in a taxable setting, ETFs, particularly if the underlying strategy's got a decent degree of turnover, have a very substantial tax advantage relative to a mutual fund.

Wallace: OK. So a taxable account, it could make a big difference?

Johnson: It could.

Wallace: 401(k)s, IRAs.

Johnson: Absolutely.

Wallace: Russ, I had a question for you. Could you discuss some of our under the radar funds that we rate highly? What we mean by that is funds that have relatively small asset bases but we rate them highly.

Kinnel: Right. So if you look for a small asset-based fund, I think there's two appealing things. One is you know they have the flexibility to really use their strategy fully as opposed to a fund that's maybe got an asset bloat and maybe can't fully execute its strategy anymore. And then two, it's also kind of a contrarian signal because small usually means out of favor. So some funds in that vein I like are Berwyn fund, ticker BERWX. We rate it Bronze. It's a micro cap focused fund. Again, that small asset base is good for investing in micro caps because there's so little liquidity. On the downside, being small means their fees on the fund are not great.

I also like LKCM Equity, LKEQX. It's a good large-cap fund. That asset size doesn't matter so much for executing its strategy, but again, because of energy, it's underperformed a bit, but I still like it a lot. We rate it Silver. I even have, most contrarian of all, a 1-star recommendation. Tweedy, Browne Worldwide High Dividend Yield, TBHDX. It's a fund that's a global focus, but it's been significantly underweight the U.S. and that's really hurt performance, but again, as we were talking about earlier, that may well shift. We might see foreign lead the next few years, in which case, the tables may turn for this fund. It might turn around.

Wallace: OK. And actually, that blends in well with another reader question that we got. And that's: what should I do with a mutual fund that's been underperforming the market for the past three years and now has a 1-star rating by Morningstar. What should investors do with a laggard in their portfolio?

Kinnel: Yes, so I think first you want to know why did it under perform? Was it that they did something, that they messed up? Did the manager change? Have fees gone up? Or is it simply that the strategy is out of favor. For instance, the Tweedy fund that I mentioned, you can see these are good managers, stable managers, a sound strategy, and it's just out of favor. But more often, the 1-star fund is because the fund maybe isn't that good, maybe it's high cost, maybe it's got some other flaws. You really want to understand the issues at that fund but also recognize that virtually every fund is going to underperform for a three-year period, especially if you're talking about active management. Even the best managers are going to underperform. If you look at just about any good fund, you'll actually be able to find some periods of underperformance, so you don't want to read too much into a three-year period. I can think of some really good funds, like Oakmark Select that have had moments where their three-year performance looked lousy but they came roaring back. You need a little more, I think. The long-term record matters but also all those fundamentals, too.

Wallace: OK. And we just have a few minutes left here, but I want to ask a nosy question, and I want to see if you would mind sharing any of the best ideas you have in your own personal portfolio. We don't have too much time to go into it, but if you could name a couple of names we'd appreciate it.

Kinnel: Sure, I'll start. I own Dodge & Cox International Stock, Vanguard Tax Managed Capital Appreciation. That's passive fund, not too different from Ben's Vanguard Total Stock Market. And Vanguard Capital Opportunity, VHCOX. It's closed but it's similar to the Primecap fund I mentioned at the top of the show. All outstanding funds with low costs.

Wallace: OK.

Johnson: The single largest fund holding I have is actually the Institutional Share Class of Vanguard Total Stock Market Fund, which I own in out 401(k). We have the good fortune of having a fantastic fund lineup in our 401(k), courtesy of Russ. Most of the other funds I own are funds that Russ has already named.

Wallace: Thanks to Russ, that's also my largest holding.

Johnson: Thanks, Russ.

Kinnel: You're welcome.

Wallace: OK. Now that we've covered the equity portion of your portfolio, a lot of investors think about dividend-paying stocks as a key part of their retirement portfolio. We have Morningstar's Travis Miller here, and he's going to give us a discussion of where dividend stocks are today, as well as some of our favorite stocks.

Travis Miller: Dividends are an important part of an investor's stock portfolio. Dividends can offer really total returns as well as income for investors. The question is, right now, what do dividend-paying stocks do in a rising interest-rate environment and what should investors do with dividend paying stocks in a rising interest-rate environment. 

We've seen Treasury yields go from 1.5%, near all-time lows, back last fall, to 2.4% today. That's a remarkable rise. Yet the S&P 500 has performed well. And the yield has stayed about 2.2%. This raises an interesting question as to how the relative performance compares to the absolute performance.

When we were at 1.5% and the S&P 500 was still at 2.2% yield, that looked like a very attractive total return package. Not only could the dividend yield fall to meet the U.S. Treasury rate, thus stocks go up, it also gave investors a good relative income stream versus bond rates. 

Now, going forward at 2.4% Treasury yields and 2.2% S&P 500 yields, it's still looks like a pretty good income at the 2.2% S&P 500 yield, but it doesn't look relatively nearly as good versus 10-year Treasury rates and other bond yields. We think it's a lot less attractive right now to own dividend-yielding stocks than it was six months ago, yet we still think dividend-paying stocks are an important part of a portfolio.

In this environment, if you're looking for dividend-paying stocks, we think you should focus on two things. One is growth, and one is the ability for the income-oriented company to continue paying that dividend. What we look at there is the payout ratio. There are two ways that a company can grow the dividends. One is through revenue growth and ultimately earnings growth. The other is through increasing a payout ratio. If you're looking at a stock that has a steady business and a good income stream with solid earnings, we think it's very important to look at the payout ratio. Is management paying out the appropriate amount of money, relative to their business mix and the consistency of their business and cash flows? We think for high dividend-paying stocks with steady cash flows, a payout ratio above 50% is reasonable. Thus, if you find a good business with a steady cash flow stream that's paying below 50% on a payout ratio, there could be opportunity to grow the dividend faster than what you'd expect from revenue or earnings growth. 

The other thing we think you should at is the business quality. At Morningstar, we group these into what we call economic moats. We think good dividend paying stocks in the wide-moat and narrow-moat categories are going to be your most consistent and growing dividend opportunities. Three businesses that we think qualify for good dividend-paying stocks include Amgen, a healthcare company; Dominion Resources, a utility; and Qualcomm, a tech company.

Amgen is one of the oldest biotech firms in the country. What we like about it is that it has a good, stable product base with older products and new growing products that can provide topline growth. Management has been very committed to the dividend since it initiated one. In the last five years, the dividend's grown 26% on an annual average basis. Right now, the payout ratio is still only 40%, and we think that can grow higher, accelerating dividend growth. Amgen is also a wide-moat stock, which gives us confidence that management will be earning returns on capital greater than the cost of capital, and supporting the dividend strength for many years.

Another stock we like on the dividend side is Dominion Resources. This, like Amgen, is a wide-moat stock with a long runway of consistent cash flows that can grow at an accelerating pace. Dominion is a utility based in the East Cast, that's benefiting from low cost natural gas that's going throughout the system in the eastern U.S. Its combination of growing pipeline investments and electric infrastructure investments gives it earnings growth that we think can top 7% over the next five years. Plus its payout ratio is lower than what management is targeting. We think the payout ratio can go up from 60% to 70% or even 75%, given the constructive regulation and the wide-moat assets that it has. When you take that payout ratio and the earnings growth potential, we think dividend growth can top earnings growth, up near 8% or 9% even for the foreseeable future.

Most people wouldn't think about technology as a sector to find steady, growing dividends, but we think Qualcomm fits that bill. Qualcomm owns the IP behind the 3G network. As smartphones grow, so does Qualcomm's licensing revenue that it charges for smartphone makers. That fee that they earn should provide a steady, growing revenue stream that can support the dividend. Management also, like the others, is committed to the dividend. Over the last five years, the dividend has grown 20% on an average annual basis. We don't think it can grow that fast for the next few years, but we do think that it can be a steady dividend grower, and it's one of the cheaper stocks that we cover right now with strong dividends.

There's still a lot of good companies that pay dividends out there. Some of those are household names, like Proctor & Gamble, Altria, and Coke. They all have strong growing cash flows that support good dividends. The big problem right now is valuations. As interest rates have gone down and as dividend paying stocks has looked more attractive as income opportunities, the multiples and valuations have gone sky high for a lot of these names. We still see utilities and some of the consumer defensive names trading well above historical multiples. When utilities are trading at 18 times earnings and typically only trade at 15 or 16 times, that creates a big headwind for investors on the valuation side.

If rising rates bring valuations down, there are a couple of names that we think investors should keep on their radar screen. One of those is Proctor & Gamble. The other is Altria. Both of these firms yield 3%, well above the 2.2% S&P 500 average dividend yield. We think they can grown the dividend steadily for many years but they're just way too pricey right now.

REITs are another sector where dividend investors typically find good steady income, but right now, they're also just way too expensive. One stock to keep an eye on is Realty Income. It still yields 4%, well above other dividend paying stocks you might find on the market right now, but we think it's too pricey. The other issue is its cap rates on new investments are falling. This could slow dividend growth into the future.

Wallace: Many investors as they approach retirement, increase their allocation to bonds and ratchet down their allocation to equities. We're now joined by Sarah Bush. She's director of fixed-income manager research here at Morningstar. 

Sarah, thanks so much for being here.

Sarah Bush: Thanks so much for having me.

Wallace: We have gotten many reader questions, and it seems like the Fed is on investors' minds. They could raise rates as early as next week. How should investors think about bonds and bond funds with rates potentially headed upward?

Bush: A couple of thoughts there. First of all, the Fed is definitely expected to be more active this year than they have in a very, very long time. We had one rate hike last year. I think right now the markets are pricing a rate hike in March at about 90%. So this is something investors could probably expect to see happen. That said, our recommendation is really that people take a long-term view. You want to understand that interest-rate risk you have in your portfolio. You certainly want to understand what kind of losses you could see, especially if you have money that's put away for short-term uses, but I don't think that it makes a lot of sense to be making huge changes to your portfolio around rate risk.

Wallace: When we say that rate affects bonds in different ways, how exactly does the Fed raising rates, how does that affect the bond yield curve and bonds of different maturities?

Bush: That's a very good point because where the Fed is active is at the short end of the yield curve. The rates that they're raising are really, really, really short term rates and what a lot of investors have exposure to is they look at, say, an intermediate core bond fund, is out the yield curve. And in fact, it's not always obvious what's going to happen with bonds out the yield curve, so longer maturity bonds, when the Fed hikes rates. My colleague, Eric Jacobson, actually wrote an interesting article about this. It was on Morningstar.com fairly recently that looked at past rate hike cycles. In 1994, to go back to ancient history, we had Fed rate hike and long-term bond yields went up pretty dramatically, and you saw pretty big losses on bond funds that were kind of in that intermediate-term range. If you look to kind of the 2004 to 2006 rate hike cycle, actually long-term bonds did OK. There was volatility so people saw some losses here and there along the way, but ultimately long-term bonds did reasonably well and the yield curve just flattened. You saw much more of a hike on the short end of the curve.

Wallace: OK. Can you recommend some picks for investors who might want to minimize their exposure to interest rates?

Bush: Yeah, certainly if you are thinking about which bond funds are most vulnerable to losses with rate hikes or with the yield curve shifting up, it's going to be short-term funds you're going to expect to do well and longer term funds, there is that increased risk of volatility. You'll have to get more yield to compensate you for that. In the short-term space, a couple of funds that we recommend. First of all, expenses are really, really important when you're at the short end of the yield curve because especially right now, rates are still very low. So an index fund is actually a pretty good option here. So Vanguard Short Term Bond Index, VBISX. Very, very, very low cost fund and that's kind of a nice choice where you're looking at a part of the market where you're not going to get a lot of yield.

If you want to take a little bit more risk, not interest-rate risk but more credit risk, which gives you a little bit more yield and a little bit more long-term total return potential out of your fund, we like Baird Short Term Bond, BSBIX. That's a strategy, it's not very aggressive. It has a little bit of credit risk in it. Very talented kind of long term, stable management team at Baird. And also pretty low expenses for an actively managed fund, so that's something you still want to be paying attention to.

Wallace: OK. What do we mean when we say core bond fund, and what are some options that you and the team like for that core bond fund allocation?

Bush: Right, so we throw that term around a lot. When we think about core bond funds, we are typically talking about funds that are intermediate-term bond category. So those are funds with that intermediate duration, so that's kind of in the middle if you think of lots of interest-rate risk being long and very little interest-rate risk being short, intermediate's kind of in the middle of that space. And then, they kind of tend to be higher quality funds. Some of them may hold some high yields, but the focus is on investment grade debt, so not as much credit risk as you might see in say a high-yield fund.

A couple of names there that we really, really like. These are Gold-rated funds. Fidelity Total Bond, FTBFX. Fidelity has built real expertise across a range of fixed-income sectors. They're very good a mortgage investing. They're very strong investing in corporates, including a little bit of high yield. They have a good emerging-markets team. So this fund, as its name suggest, Total, kind of invests across the bond markets. It is a little bit at the riskier end of that intermediate-term bond category but still a pretty high-quality fund. Very established management team and nice expense ratio as well.

Another one that we look at, and it's also in the Gold space in the intermediate-term bond category, is Metropolitan West Total Returns. They're a team we've like for a long time. Very experienced team. MWTRX. Depth of resources. They actually pretty actively manage duration. The Fidelity fund doesn't manage interest-rate risk. They do, so they're kind of at the shorter end right now because they are thinking about the potential for rates to be rising, so this is a fund that might do relatively well in that intermediate-term bond space if rates do increase. And they have a nice range of investments and expertise. It's really a very deep team. So it's another strategy that we quite like.

Wallace: OK. You talked earlier about credit risk. What are some options for investors who might not mind taking a little bit more credit risk in their bond fund?

Bush: Right. So if you start going out into the world of credit risk, we're talking about funds in our multisector category or in a high-yield category. One strategy we quite like in the high-yield space is Fidelity High Income. I mentioned earlier that Fidelity has a very good high-yield team. This is managed by a manager, Fred Hoff, who's been there a really long time, a lot of experience through a different credit cycles, which we think really brings some perspective to thinking about how to navigate today's environment. And then, Fidelity is really invested in the analyst resources. When you're looking at high yields, you need to have analysts out there who can go and really understand what kind of risk you are taking in individual companies that you might be investing in. This is also a bell priced fund, so it's a strategy we like quite a bit.

In the multisector space, Loomis Sayles Bond is another fund we like a lot. I think it's probably familiar to people because Dan Fuss is really very well known in the bond space, but they've done a nice job of kind of building out that team. He's got some strong comanagers there. Again, a lot of analyst resources. When we talk about funds that you wan to have a long time horizon for, both the Fidelity Fund and the Loomis Sayles Fund, I think this is very important because they do take on more credit risk. With Loomis Sayles, they tend to be fairly contrarian, so you can see periods of time when they're starting to get in. Maybe we have high yields suddenly loses a bunch of money and they suddenly see real opportunities to get in and buy bonds at good prices, so you might see those losses during that time period, but over the long haul they've put together a very strong record with that approach.

Wallace: Got it. So these managers have a long time horizon so it's best matched with an investor with a longer time horizon.

Bush: Right. To really benefit from those types of strategies, you have to be willing to hold through some volatility.

Wallace: OK, thanks. What sorts of bond funds would you recommend for investors who are investing in a taxable account?

Bush: Right. So then you're going to be thinking about municipal bonds that do provide a tax advantage, right, so that income is not taxable. A couple of shops that we like there. You've heard a lot of Fidelity from me today. They also have a very good team. Also, the other thing we like about Fidelity is their funds are well priced. They're cheap. So it's a theme you're going to hear. But they have a good team on the municipal side. Again, the right analyst to do the research to make sure that they're making good choices. Also, this is a relatively conservative strategy, which we like. I think a lot of times when people are looking at their muni funds, they're not wanting to take a lot of risk. Duration-neutral, so they're not making big bets about the direction of interest rates.

Another one that we like on the municipal side is T. Rowe Price Tax Free Income, PRTAX. Again, sort of similar story, just very well-resourced team. They don't get into a lot of Puerto Rico or tobacco bonds, which are parts of the market that carry more credit risk and can kind of get you into trouble from time to time, so this is a nice kind of plain-vanilla strategy, maybe a little bit more on the credit risk side, but just a very very strong team and a strategy that we like.

Wallace: OK, if we could back up. What are municipal bonds, and why do they make sense for taxable accounts?

Bush: Right, so I think the main attraction to municipal bonds is that the income is not taxable, so that that's something that's quite attractive. If you're looking at the income on a taxable bond fund, so Loomis Sayles Bond, or what we were talking about on the high yield side, you are paying taxes on that income. In terms of what municipal bonds do, they finance municipalities. We're here in Chicago. Chicago bonds are actually sort of a hot topic among municipal managers today. They finance school districts. They finance states. They finance healthcare facilities. Just a range of purposes, but that tax-free component I think is what's of most interest to investors.

Wallace: Got it. OK. If we could touch on inflation, just a bit. We've gotten some reader questions about that. After being tame for a few years, we're seeing some signs that inflation is picking up again. How should investors think about inflation protection in their portfolio, and what are some funds that you and the team could recommend for that?

Bush: Sure. We are certain as we talk to bond fund managers, everyone is, I think for a couple of years, people have started saying, you know, we're concerned. Before everyone was worried about deflation. Now we're starting to hear managers say, OK, well the economy is doing pretty well. Depending on what comes out of Washington, we might see some fiscal stimulus. Those are all factors that could start to push inflation up. I don't think anyone expects it to get wildly out of control, but certainly that's something that, if you don't have, you know you can start seeing it eat away at your portfolio on kind of a real basis because you're able to purchase less with the same dollar. I think it's a fair question to be thinking about it in your portfolio. Obviously there's some nonbond ways to get inflation protection, so equities, for example, are an investment that can provide some inflation protection.

On the bond side, the most obvious place to go is to Treasury Inflation-Protected Securities. So these actually have an adjustment up to pay you for inflation basically, to kind of keep you even with inflation. TIPS bonds, which we call, that's our name for Treasury Inflation-Protected Securities. That's the nickname. They tend to be pretty volatile though. One fund that we really like, Vanguard has a short-term TIPS fund, Vanguard Short Term Inflation Protected, VTIPX. What's nice about that is, first of all, the short part, short-term maturity TIPS tend to actually trade a little bit more with inflation, so you're getting that inflation protection but you're not taking the same kind of volatility risk that you would if you had the whole TIPS market. So that's a nice type of fund to be looking at.

Wallace: That's interesting. They offer inflation protection but not necessarily interest rate protection.

Bush: Absolutely, and if you look at 2013, which was one the last times we had a big sell-off, in the rate market, TIPS did terribly. It is important to understand, especially if you go into TIPS funds that are in that full market, maybe have a little bit more of that interest-rate risk, that they can be very volatile.

The other place you can look for inflation protection, and I think Christine Benz has written about this before, is in the bank loan space. So bank loans, they're floating rate, basically loans to companies. They're not securitized but they're kind of packaged up and you can buy them through, you can buy funds that invest in them. They're interesting. First of all, they're lower credit quality so these companies would do well if the economic was doing well. That's a good--usually, if you see inflation  picking up because of economic growth, these companies are likely to do fairly well. And then, the other piece of it is that they're actually floating rates, so if interest rates are going up at the same time your bank loan is going to adjust upward in terms of the yield that you're getting paid. So it means that you don't have that interest-rate risk piece and you very quickly start to realize additional income as rates go up.

Wallace: I'm going to take another reader question here. This comes from a reader who wants to know if they should only be invested in short-term bond funds at this time. How do you think about your bond allocation?

Bush: That's a good question, and it's one I see pop a lot on .com and people asking that question. I think a couple of things. First of all, you need to understand why are you holding bonds. If you are holding bonds because you have some kind of short-term purpose and you want them really to provide liquidity and you are not able to tolerate any fluctuations at all, then maybe a short-term bond fund, which could still see a little bit of interest-rate-related volatility, maybe a short term bond fund is a good place to be. That said, I think a lot of times it's important to consider your broader portfolio. People may be holding bonds because they're looking for diversification. They're looking for them to protect them, if there's, say there's a big sell-off in the equity markets. Typically high quality bond funds do pretty well. And so that if you're holding them for diversification in a longer term approach, it's probably best to keep some of those funds with some interest-rate sensitivity because those are the ones that are going to do relatively well to kind of offset the volatility from the equity part of your portfolio.

One other thing to consider is that the yield curve is upward sloping, so that means you get paid more interest for being in longer term bonds. If you're going to hang out in short-term bonds, you're actually giving something up. That sort of yield curve, that goes up, is paying for that interest-rate risk. So it's another reason, especially if you have a longer time horizon and you can take a little bit of volatility over the short term, to maybe consider intermediate-term bond fund. The other piece I always like to remind people is if interest rates go up, you're actually getting paid more as an investor so ultimately that's a good thing.

Wallace: OK. I have one more question for you, and that's nearly all active categories experienced outflows in 2016, but some notable exceptions were taxable bond categories. In what ways might investors be better off seeking out actively managed funds in fixed-income categories?

Bush: That's a good question. I think it's kind of different answer than what we've seen on the equity side. If you look at that intermediate-term bond category, active funds have actually done really well over the past five years. That's partially, or to large extent, because they're actually taking more risk. We still actually think the Vanguard Total Bond Market Index is a very good option, very cheap, especially for people who don't want to take on credit risk, so we think that's still a good fund. But for people looking for a little bit more total return potential, we mentioned some of those core bond funds earlier, Fidelity Total Bond, for example, where by investing in an active option that gives you exposure to high yield, emerging markets, where managers can add value through credit research, through managing the liquidity of the fund, we think that's actually a pretty attractive option. 

As you go out to other parts of the market, the index funds are not as well established and high yield is an area where index funds have really struggled and have pretty poor performance profiles relative to active funds. So that's a place where we think it definitely makes sense to be active.

Wallace: OK. Sarah, thank you so much for being here today to share your insights.

Bush: Thanks for having me.

Wallace: As a reminder, we'll be sending out a packet with all the picks mentioned in this panel to everyone who registered for this conference. Thanks so much for watching. I'm Karen Wallace for Morningstar.

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